7 Practical Lessons to Make You The Millionaire Next Door
I recently sat down and finished a personal finance classic: The Millionaire Next Door by Thomas J. Stanley and William D. Danko. Originally published in 1996, this 25-year old book has been through numerous updates to shed light on what it truly means to be wealthy in the United States. The revelation? The profile of a typical millionaire is very unlike what we assume through glamorous magazines and flashy TV shows.
To be honest, the concepts introduced in the book are nothing mind-blowing or novel. However, precisely due to the ‘blandness’, many of us ignore them as cornerstones of wealth accumulation until it is too late. Without further ado, let me share my 7 takeaways to bring us a step closer to become… The Millionaire Next Door!
1. How Much Should You Be Worth?
The authors developed a simple rule of thumb after years of surveying high net worth and high income people:
Expected Worth = Age * Realized Pretax Annual Household Income from All Sources Except Inheritances / 10 — Inherited Wealth
So theoretically, the higher your income or older you are, the greater your net worth should be. Caveat here: the formula makes more sense if you worked at least >5 years and are not a fresh grad; after all, you likely didn’t have any income during school.
This corroborates with the study done by DQYDJ where there is lower correlation between income and net worth for young people (18–29), and higher correlation from middle age onwards.
If your actual net worth is twice the level of expected worth, you’re a Prodigious Accumulator of Wealth (PAW). If your actual net worth is half, you’re an Under Accumulator of Wealth (UAW).
This means that a 40-year old small business owner earning $100k vs. a 40-year old lawyer earning $400k are expected to have net worths of $400k and $1.6 million respectively. It may seem like the latter is not too difficult with the income, but the lifestyle expected of a high-flying lawyer typically translates to exorbitant expenses that may land him/her as a UAW.
Meanwhile, the small business owner does not face much societal pressures to own a fancy car, live in a fancy house or wear fancy clothes — and may easily be a PAW as a result.
Personally, I am an Average Accumulator of Wealth based on the formula currently and I am cool with the results, signifying I have room to grow.
What is yours? Are you surprised by the outcome? That said, do take note that this is just a rough gauge.
2. Net Worth and Income are Different — Focus on Net Worth
I have explained net worth previously: it is assets (what you own) LESS liabilities (what you owe). If I buy a house worth $1m but end up with a mortgage of $750k, my net worth is $250k, not $1m. Buying an expensive home may increase your assets, but your net worth suffers if you end up with an unsustainable mortgage.
We often identify rich people as those with typical high-income occupations, such as doctors and lawyers. However this perception is primarily based on income only. We need to look at the other side of the formula.
Once you’re in a high-income bracket of above $100k-200k per annum, it matters less how much more you make, than what you do with what you already have.
Our personal financial goal should aim to increase our net worth i.e. increasing assets while decreasing liabilities. Don’t forget the latter. To quote from another classic Rich Dad Poor Dad:
The rich buy assets. The poor only have expenses. The middle class buy liabilities they think are assets. (read: things like luxury cars and luxury bags) — Robert Kiyosaki
3. Millionaires Play Great Offense AND Defense
Many people focus on playing great offense (generating higher than average income) but neglect defense (being prudent and frugal in spending).
The authors concluded that most millionaires play both quality offense and quality defense through careful budgeting and prudence. Often, it is their great defense that helps them outscore those who outearn. They do not allow their income to define their budgets, or what we also know as lifestyle inflation.
Why is lifestyle inflation prevalent? According to the authors, it is because the US is a highly consumption-oriented society. I believe this is the same all around the world today. Consumerism been a cultural trait in America, where we have omnipresent online/offline ads, social media pressure, easy credit and increasingly shopping festivals that happen almost monthly (6th June, 7th July…).
Additionally, the authors give some advice on house purchases: never purchase a home that requires a mortgage more than twice your household’s total annual realized income. Living in a less costly area can enable you to spend less and invest more.
The simple reason? You’ll find less need to keep up with the Joneses if your neighbours do not drive flashy cars.
4. Millionaires Prioritise Time Planning Their Financial Future
Millionaires became millionaires by planning financially, and maintain their affluent status the same way — by setting aside significant portion of their time to budget, invest and control expenses.
This is akin to those people who jog daily — they may seem not to need jogging, but that’s precisely why they’re fit. Those who are wealthy work at staying financially fit, but those who are not financially fit do little to change their status.
PAWs allocate nearly twice the number of hours per month to planning their financial investments as UAW do.
A typical millionaire household said YES to the following 4 questions:
- Does your household operate on an annual budget?
- Do you know how much your family spends each year for food, clothing, and shelter?
- Do you have a clearly defined set of daily, weekly, monthly, annual and lifetime goals?
- Do you spend a lot of time planning your financial future?
Their common financial habits include:
- Investing at least 1/3 of pre-tax household income annually
- Using 1 central credit card for most purchases
- Both partners budget together and are aware of their household expenditures
- Reviewing allocation regularly and perform next year’s budgeting
5. Millionaires Minimize Realized Income and Maximize Unrealized Income
To build wealth, minimize your realized (taxable) income and maximize your unrealized income i.e. capital appreciation without cash flow.
Many high-income-producing households are asset poor, because they maximize their realized incomes, to support high-consumption lifestyles.
The typical millionaire has a total annual realized income of less than 7% of his wealth. This was quite shocking to me. This means less than 7% of a millionaire’s wealth is subject to income tax and 93% of his wealth continues growing freely, enjoying the magic of uninterrupted compound interest.
Once again, this corroborates with Lesson 1 of Rich Dad Poor Dad: the rich don’t work for money. We should focus on acquiring passive and portfolio income, over earned income.
6. Millionaires are Mostly Business Owners — Higher Education has its Drawbacks
80% of millionaires studied are first-generation millionaires. They built their own wealth, not from inheritance. Many are self-employed professionals in unexciting fields like auctioneers, factory owners.
Sadly, this effect did not seem to pass down generationally. The authors found that the children of PAWs are often less economically productive because the affluent parents, who had made their wealth being self-made entrepreneurs, did not want their children to go through similar hardships. Instead they wanted them to have a ‘better life’, defined by society to broadly include a higher education and higher-esteemed occupation choice.
Paradoxically, being well-educated has certain economic drawbacks. These children grow up learning that a higher level of consumption is expected of people who spent many years in college. As a result, they take on ‘safer’ higher-income occupations, which curtails risk-taking. Ironically this also demands them to look the part and consume more.
Now, I do not think the authors are against the pursuit of higher education and neither am I. It depends on the education system — rote education stifles creativity while the open-minded use case-based learning method is more conducive to innovation and entrepreneurship.
7. Millionaires Avoid Excessive Consumerism
Millionaires “believe that financial independence is more important than displaying high social status.” The authors’ research found an inverse relationship between time spent checking out luxury items and time spent planning one’s financial future.
More often than not, excessive symbols of economic success are ways one convinces others of their success. It becomes a pointless cycle as you fail to convince the most important person of all: yourself. Rather, spend just enough on a few quality pieces and wisely save/invest the rest.
4 Actionable Steps
- Establish and maintain a budget for annual and monthly expense categories, and record the expenses to monitor allocation on a quarterly basis (I use the free Monefy app for actual expenses and import them to Google Sheets to tally against the budget) — you cannot control what you cannot monitor
- Invest at least 1/3 of realized household income a year, particularly invest in growing assets
- Keep up with the habit of quarterly financial reviews and monthly portfolio reviews
- Increase passive and portfolio income streams, by pursuing side hustles and investing consistently
Concluding Thoughts
Against the backdrop of day-trading, zero-fee trading platforms and stories of crypto billionaires, it is easy to expect quick gains with minimal hard work, neglecting old-age virtues such as frugality and patience.
This book reminded me that there is no shortcut to true wealth accumulation; it takes hard work, discipline, self-control, patience and time.
I revamped my budget and shall be tracking my expenses diligently in the Monefy app so that I can reach my savings and investing goals of 2021. I will strive to keep up with good financial habits, and hope that my takeaways from this book have motivated you to do so too.
Thanks for reading! If you found this useful, please return a clap, it means a lot to me :)
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